Contents

1 Carr-Jarrow-Myneni Model (1992)

1.1

1.2

American Call Option Pricing Model . . . . . . . . . . . . . . . . . . . .

1.1.1

Early Exercise Premium . . . . . . . . . . . . . . . . . . . . . . .

1.1.2

Boundary Condition . . . . . . . . . . . . . . . . . . . . . . . . .

American Put Option Pricing Model . . . . . . . . . . . . . . . . . . . .

1.2.1

Early Exercise Premium . . . . . . . . . . . . . . . . . . . . . . .

1.2.2

Boundary Condition . . . . . . . . . . . . . . . . . . . . . . . . .

2 Ju Model (1998)

2.1

N-Piece Exponential Function . . . . . . . . . . . . . . . . . . . . . . . .

2.2

Determine the Parameters of Boundary . . . . . . . . . . . . . . . . . . .

10

2.2.1

Value-Matching . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

2.2.2

High-Contact . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

Chapter 1
Carr-Jarrow-Myneni Model (1992)
Carr, P., R. Jarrow, and R. Myneni, 1992, Alternative Characterizations of American
Puts, Mathematical Finance, Vol. 2, 87-106.

1.1
1.1.1

American Call Option Pricing Model

Early Exercise Premium

Consider an American call option on the stock with strike price K and maturity date T .
Let C A (t, St , K, T ) denote the value of the American call option at time t [0, T ]. For
each time t, there exists a critical stock price, Bt , above which the American call option
should be exercised early, i.e.,
C A (t, St , K, T ) = H (t, St , K, T ) 1{St <Bt } + (St K) 1{St Bt } ,

(1.1)

where H (t, St , K, T ) is the value of option with continuing to hold. This boundary is
independent of the current stock price St and is a smooth, non-increasing function of
time t terminating in the strike price, i.e. BT = K.
Given the filtration F0 , the American call value, C A (0, S0 , K, T ), can be decomposed
into the corresponding European call price, C E (0, S0 , K, T ), and the early exercise premium, (0, S0 , K, T ):
C A (0, S0 , K, T ) = C E (0, S0 , K, T ) + C (0, S0 , K, T ) ,
where
C

(0, S0 , K, T ) =



qS0 eqt N (d1,t,S0 ) rKert N (d2,t,S0 ) dt,

(1.2)

d1,u,S0



S0
1 2
ln
+ rq+ u
Bu
2

,
=
u

d2,u,S0 = d1,u,S0 u.

Proof. Let CtA := P A (t, St , K, T ), Ht := H (t, St , K, T ), and CtE := P E (t, St , K, T ).

Given the filtration F0 , by the first fundamental theorem of asset pricing, the dynamic
process of discounted value, ert CtA , for the American call option is a martingale only if
the American call option is not exercised early. By Itos lemma,


A
C A
1 2 CtA 2
rt A
rt A
rt Ct
de Ct = re Ct + e
dt + ert t dSt +
dSt
t
St
2 St2


A
CtA CtA
1 2 CtA 2 2
A
rt
rt Ct
rCt +
=e
+
(r q) St +

S
dt
+
e
St dWtQ .
t
2
t
St
2 St
St
And, each derivative w.r.t t and St is
CtA
Ht
=
1{St <Bt } ,
t
t

CtA
Ht
=
1{St <Bt } + 1{St Bt } ,
St
St

2 CtA
2 Ht
=
1{St <Bt } .
St2
St2

The dynamic process of discounted value is rewritten by



2 Ht 2 2
Ht Ht
rt A
rt
de Ct =e
(r q) St +
St 1{St <Bt } dt
rHt +
+
t
St
St2
C A
ert (qSt rK) 1{St Bt } dt + ert t St dWtQ .
St
Owing to
2 Ht 2 2
Ht Ht
+
St = rHt ,
(r q) St +
t
St
St2
the discounted value of American call option at time T is
Z T
Z T
C A
rT A
A
rt
ert t St dWtQ .
e (qSt rK) 1{St Bt } dt +
e CT = C0
St
0
0
At maturity, the payoffs of American and European are the same, i.e.
CTA = CTE = (ST K) 1{ST >K} .
Thus, the value of American call option at time 0 is


Z T
Z T
A
Q
Q
A
rT E
rt
rt Ct
St dWt
C0 = E0 e CT +
e (qSt rK) 1{St Bt } dt +
e
St
0
0

Z T
Q
E
rt
=C0 + E0
e (qSt rK) 1{St Bt } dt
0
Z Tn
 1 2


o
Q
E
2 t+ tt
=C0 +
qS0 eqt EQ
e
1

rK
E
1
dt
{St Bt }
{St Bt }
0
0
0
Z T


E
=C0 +
qS0 eqt N (d1,t,S0 ) rKert N (d2,t,S0 ) dt.
0

1.1.2

Boundary Condition

The early exercise boundary Bt , solves the following integral equation:

Z T


E
Bt K = C (t, Bt , K, T ) +
qBt equ N (d1,u,Bt ) rKeru N (d2,u,Bt ) du.

(1.3)

Once Bt , is obtained, the price of the American call can be calculated easily.

1.2
1.2.1

American Put Option Pricing Model

Early Exercise Premium

Consider an American put option on the stock with strike price K and maturity date T .
Let P A (t, St , K, T ) denote the value of the American put option at time t [0, T ]. For
each time t, there exists a critical stock price, Bt , above which the American put option
should be exercised early, i.e.,
P A (t, St , K, T ) = H (t, St , K, T ) 1{St >Bt } + (St K) 1{St Bt } ,

(1.4)

where H (t, St , K, T ) is the value of option with continuing to hold. This boundary is
independent of the current stock price St and is a smooth, non-decreasing function of
time t terminating in the strike price, i.e. BT = K.
Given the filtration F0 , the American put value, P A (0, S0 , K, T ), can be decomposed
into the corresponding European put price, P E (0, S0 , K, T ), and the early exercise premium, (0, S0 , K, T ):
P A (0, S0 , K, T ) = P E (0, S0 , K, T ) + P (0, S0 , K, T ) ,
where
Z

(0, S0 , K, T ) =



rKert N (d2,t,S0 ) qS0 eqt N (d1,t,S0 ) dt

=K 1 erT S0 1 eqT + C (0, S0 , K, T ) ,

d1,u,S0



S0
1 2
+ rq+ u
ln
Bu
2

,
=
u

d2,u,S0 = d1,u,S0 u.

(1.5)

Proof. Let PtA := P A (t, St , K, T ), Ht := H (t, St , K, T ), and PtE := P E (t, St , K, T ).

Given the filtration F0 , by the first fundamental theorem of asset pricing, the dynamic
process of discounted value, ert PtA , for the American put option is a martingale only if
the American put option is not exercised early. By Itos lemma,


A
P A
1 2 PtA 2
rt Pt
rt A
rt A
de Pt = re Pt + e
dt + ert t dSt +
dSt
t
St
2 St2


A
PtA PtA
1 2 PtA 2 2
A
rt Pt
rt
rPt +
+
(r q) St +
dt
+
e
St dWtQ .
=e

S
t
t
St
2 Pt2
St
And, each derivative w.r.t t and St is
PtA
Ht
=
1{St >Bt } ,
t
t

PtA
Ht
=
1{St >Bt } 1{St Bt } ,
St
St

2 PtA
2 Ht
=
1{St >Bt } .
St2
St2

The dynamic process of discounted value is rewritten by



2 Ht 2 2
Ht Ht
rt A
rt
+
St 1{St >Bt } dt
de Pt =e
(r q) St +
rHt +
t
St
St2
A
rt
rt Pt
St dWtQ .
e (rK qSt ) 1{St Bt } dt + e
St
Owing to
Ht Ht
2 Ht 2 2
+
St = rHt ,
(r q) St +
t
St
St2
the discounted value of American call option at time T is
Z T
Z
rT A
A
rt
e PT = P0
e (rK qSt ) 1{St Bt } dt +
0

ert

PtA
St dWtQ .
St

At maturity, the payoffs of American and European are the same, i.e.
PTA = PTE = (K St ) 1{ST <K} .
Thus, the value of American put option at time 0 is


Z T
Z T
A
Q
Q
A
rT E
rt
rt Pt
St dWt
P0 = E0 e PT +
e (rK qSt ) 1{St Bt } dt +
e
St
0
0
Z T

Q
E
rt
=P0 + E0
e (rK qSt ) 1{St Bt } dt
0
Z Tn
 1 2
o


E
qt Q
2 t+ tt
=P0 +
rK EQ
1

qS
e
E
e
1
dt
0
{St Bt }
{St Bt }
0
0
0
Z T


E
=P0 +
rKert N (d2,t,S0 ) qS0 eqt N (d1,t,S0 ) dt.
0

1.2.2

Boundary Condition

The early exercise boundary Bt , solves the following integral equation:

Z T


E
K Bt =P (t, Bt , K, T ) +
rKeru N (d2,u,Bt ) qBt equ N (d1,u,Bt ) du
t

=P E (t, Bt , K, T ) + K 1 erT S0 1 eqT
Z T


+
qBt equ N (d1,u,Bt ) rKeru N (d2,u,Bt ) du.
t

Once Bt , is obtained, the price of the American put can be calculated easily.

(1.6)

Chapter 2
Ju Model (1998)
Ju, N., 1998, Pricing an American Option by Approximating Its Early Exercise Boundary as a Multi-Piece Exponential Function, Review of Financial Studies, Vol. 11, 627646.

2.1

N-Piece Exponential Function

Assume Bt to be an exponential function a exp (bt) for the interval [t1 , t2 ]. Given the
filtration F0 , t1 0, consider an integral
Z t2
I1 (t1 , t2 , a, b) =
reru N (d2,u,S0 ) du
(2.1)
t1





x2
x2
rt1
rt2
e
=e
N x1 t2 +
N x1 t1 +
t1
t2

 



x2 (x3 x1 )

e
x1
x2
x2
+
+ 1 N x3 t2 +
N x3 t 1 +
2
x3
t2
t1








ex2 (x3 +x1 ) x1

x2
x2

1 N x3 t 2
N x3 t 1
,
2
x3
t2
t1
where

1
r q b 2
2 ,
x1 =

S0
a ,

ln
x2 =

q
x3 = x21 + 2r.

Proof. By the integration by parts, we can get

Z t2

1
eru N (d2,u,S0 ) du = ert2 N (d2,t2 ,S0 ) ert1 N (d2,t1 ,S0 )
r
t1
Z
x
1 t2 ru
x2 3 
1 1
+
e
n (d2,u,S0 )
u 2 u 2 du
r t1
2
2






1 rt1
x2
x2
rt2
N x1 t1 +
N x1 t2 +
= e
e
r
t1
t2


x2 (x3 x1 ) Z t2 
1
1
x1 1 x 2 3 
e
n x3 u 2 + x2 u 2
u 2 u 2 du.
+
r
2
2
t1
Recall the property of normal distribution,



 x
1
1
1
1
x2 3 
3 1
d N x3 u 2 + x2 u 2 = n x3 u 2 + x2 u 2
u 2 u 2 du,
2
2



 x
1
1
1
1
x2 3 
3 1
d N x3 u 2 x2 u 2 = n x3 u 2 x2 u 2
u 2 + u 2 du
2
2

1
1
1
x2 3 
x
3
=e2x2 x3 n x3 u 2 + x2 u 2
u 2 + u 2 du.
2
2
Thus, we can easily get
Z t2 
x
1
1 1
21
2
u 2 du
n x3 u + x2 u
2
t1
Z
x
1
1
x1 t2 
3 1
u 2 du
=
n x3 u 2 + x2 u 2
x3 t1
2
Z t2

 x e2x2 x3 Z t2


1
1
x1
1
12
12
2
2
=
d N x3 u + x2 u
+
d N x3 u x2 u
2x3 t1
2x3
t1





x1
x2
x1
x2
=
N x3 t2 +

N x3 t1 +
2x3
2x3
t2
t1




2x2 x3
2x
x
2
3

x1 e
x2
x2
x1 e
+
N x3 t2
N x3 t1

,
2x3
2x3
t2
t1
and
Z

t2

x

1
1
1 1
n x3 u 2 + x2 u 2
u 2 du
2
t1
Z


 1 Z t2

1
1
1
1
e2x2 x3 t2

=
d N x3 u 2 x2 u 2
d N x3 u 2 + x2 u 2
2
2 t1
t1





e2x2 x3
e2x2 x3
x2
x2
=
N x3 t2

N x3 t1
2
2
t2
t



 1

1
x2
1
x2
N x3 t2 +
+ N x3 t1 +
.
2
2
t2
t1

Substitute the results into the initial integral, then

Z t2
reru N (d2,u,S0 ) du
t1





x2
x2
rt1
rt2
N x1 t1 +
N x1 t2 +
=e
e
t1
t2








ex2 (x3 x1 ) x1
x2
x2
+ 1 N x3 t2 +
N x3 t1 +
+
2
x3
t2
t1




 
x2 (x3 +x1 )

e
x2
x2
x1

N x3 t1
.
1 N x3 t2
2
x3
t2
t1

Similarly, given the filtration F0 , t1 0, consider another integral

Z t2
qequ N (d1,u,S0 ) du
(2.2)
I2 (t1 , t2 , a, b) =
t1





y2
y2
qt1
qt2
=e
N y1 t1 +
e
N y1 t2 +
t1
t2
 




y2 (y3 y1 )

y1
y2
y2
e
+ 1 N y3 t2 +
+
N y3 t1 +
2
y3
t2
t1








y2
y2
ey2 (y3 +y1 ) y1

1 N y3 t2
N y3 t1
,
2
y3
t2
t1
where

1
r q b + 2
2 ,
y1 =

S0
a ,

ln
y2 =

q
y3 = y12 + 2q.

Proof. By the integration by parts, we can get

Z t2

1
equ N (d1,u,S0 ) du = eqt2 N (d1,t2 ,S0 ) eqt1 N (d1,t1 ,S0 )
q
t1
Z
y
y2 3 
1 t2 qu
1 1
e
n (d1,u,S0 )
u 2 u 2 du
+
q t1
2
2






1 qt1
y2
y2
qt2
= e
N y1 t1 +
e
N y1 t2 +
q
t1
t2


y2 (y3 y1 ) Z t2 
1
1
e
y1 1 y2 3 
+
n y3 u 2 + y2 u 2
u 2 u 2 du.
q
2
2
t1
Recall the propeqty of normal distribution,


1
2

12

d N y3 u + y2 u

1
2

21

= n y3 u + y2 u

 y

12

y2 3 
u 2 du,
2




 y
1
1
1
1
y2 3 
3 1
d N y3 u 2 y2 u 2 = n y3 u 2 y2 u 2
u 2 + u 2 du
2 
2

1
1
y
y2 3 
3 1
=e2y2 y3 n y3 u 2 + y2 u 2
u 2 + u 2 du.
2
2
Thus, we can easily get
Z t2 
y
1
1
1 1
n y3 u 2 + y2 u 2
u 2 du
2
t1
Z
y
1
1
y1 t2 
3 1
=
n y3 u 2 + y2 u 2
u 2 du
y3 t1
2
Z t2


 y e2y2 y3 Z t2

1
1
1
1
y1
1

=
d N y3 u 2 + y2 u 2 +
d N y 3 u 2 y 2 u 2
2y3 t1
2y3
t1





y1
y1
y2
y2

=
N y3 t2 +
N y3 t1 +
2y3
2y3
t2
t1




2y
y
2y2 y3
2
3

y1 e
y1 e
y2
y2

,
+
N y3 t2
N y3 t1
2y3
2y3
t2
t1
and
Z

t2


y
1
1
1 1
n y3 u 2 + y2 u 2
u 2 du
2
t1
Z
 1 Z t2



1
1
e2y2 y3 t2
12
21
2
2
=

d N y3 u y2 u
d N y3 u + y2 u
2
2 t1
t1





e2y2 y3
y2
e2y2 y3
y2
N y3 t2
N y3 t1
=

2
2
t2
t



 1

1
y2
1
y2
N y3 t2 +
+ N y3 t1 +
.
2
2
t2
t1
Substitute the results into the initial integral, then
Z t2
qequ N (d2,u,S0 ) du
t1





y2
y2
qt2
qt1
e
N y1 t2 +
=e
N y1 t1 +
t1
t2
 




y2 (y3 y1 )

e
y1
y2
y2
+
+ 1 N y3 t2 +
N y3 t1 +
2
y3
t2
t1








ey2 (y3 +y1 ) y1

y2
y2

1 N y3 t2
N y3 t1
.
2
y3
t2
t1


n

Consider a n-piece exponential function, aj ebj t j=1 and tj =

jT
n

n
j=0

the value of Amer-

ican call option is approximated by

C E (0, S0 , K, T ) + S0 nj=1 I2 (tj1 , tj , aj , bj )

P
CnA (0, S0 , K, T )
K nj=1 I1 (tj1 , tj , aj , bj ) ,
S0 < a1 ,

S a ,
S 0 a1 .
0
1
9

(2.3)

And, the value of American put option is approximated by

P E (0, S0 , K, T ) + K 1 erT S0 1 eqT

+S Pn I (t , t , a , b )
0
j j
j=1 2 j1 j
PnA (0, S0 , K, T )
P
n

K j=1 I1 (tj1 , tj , aj , bj )
S > a1 ,

a S ,
S0 a1 .
1
0

2.2

(2.4)

Determine the Parameters of Boundary

To determine the series of {ai }ni=1 and {bi }ni=1 , Ju (1998) applied the value-match and
the high-contact conditions.

2.2.1

Value-Matching

For the American call option, given the filtration F0 , the value-matching condition at
each time ti =
iT

ai+1 ebi+1 n

iT
,
n

i = 0, 1, 2, , n 1, is


(n i) T
E
bi+1 iT
n , K,
K =C
0, ai+1 e
(2.5)
n
ni
ni
X
X
bi+1 iT
n
+ ai+1 e
I2 (tj1 , tj , aj , bj ) K
I1 (tj1 , tj , aj , bj ) .
j=1

j=1

For the American put option, given the filtration F0 , the value-matching condition at
iT
,
n

i = 0, 1, 2, , n 1, is




(ni)T
iT
(n i) T
bi+1 iT
E
b
i+1
n =P
n , K,
K ai+1 e
0, ai+1 e
+ K 1 er n
n


(ni)T
bi+1 iT
q n
n
ai+1 e
1e

each time ti =

+ ai+1 e

bi+1 iT
n

ni
X

I2 (tj1 , tj , aj , bj ) K

j=1

ni
X
j=1

10

(2.6)

I1 (tj1 , tj , aj , bj ) .

2.2.2

High-Contact

The derivative of equation (2.1) is

 rt1 




I1
e
x2
ert2
x2
1
= n x1 t1 +
(2.7)
n x1 t2 +
S0
S0
t1
t1
t2
t2

 




ex2 (x3 x1 ) x1
x2
x2
+
+ 1 N x3 t2 +
N x3 t1 +
(x3 x1 )
2S0
x3
t2
t1

 





ex2 (x3 x1 ) x1
x2
1
x2
1
n x3 t1 +

+
+ 1 n x3 t2 +
2S0
x3
t2
t2
t1
t1




 
x2 (x3 +x1 )

x2
x2
e
x1
N x3 t1
(x3 + x1 ) ,
+
1 N x3 t2
2S0
x3
t2
t1

 





ex2 (x3 +x1 ) x1

1
1
x2
x2
n x3 t1

+
1 n x3 t2
,
2S0
x3
t2
t2
t1
t1
and the derivative of equation (2.2) is
 qt1 




I2
e
y2
eqt2
y2
1
= n y1 t1 +
n y1 t2 +
(2.8)
S0
S0
t1
t1
t2
t2
 





ey2 (y3 y1 ) y1
y2
y2
+ 1 N y3 t2 +
+
N y3 t1 +
(y3 y1 )
2S0
y3
t2
t1

 





y2
y2
1
1
ey2 (y3 y1 ) y1
n y3 t1 +

+
+ 1 n y3 t2 +
2S0
y3
t2
t2
t1
t1

 



y2 (y3 +y1 )

y1
y2
y2
e
1 N y3 t2
+
N y3 t1
(y3 + y1 ) ,
2S0
y3
t2
t1
 






y2
y2
ey2 (y3 +y1 ) y1
1
1
n y3 t1

1 n y3 t2
+
.
2S0
y3
t2
t2
t1
t1
Let the notations I10 =

I1
S0

and I20 =

I2
.
S0

Recalling the equations (1.2) and (1.5),

the derivatives of w.r.t. S0 for the LHS and RHS are the same as S0 B0 . For the
American call option, given the filtration F0 , the high-contact condition at each time
ti =

iT
,
n

i = 0, 1, 2, , n 1, is
1 =e

(ni)T
n

N d1, (ni)T ,a
n

+ ai+1 e

bi+1 iT
n

ni
X

iT
b
i+1 e i+1 n

ni
X

I2 (tj1 , tj , aj , bj )

j=1

I20

(tj1 , tj , aj , bj ) K

j=1

ni
X
j=1

11

I10 (tj1 , tj , aj , bj ) .

(2.9)

For the American put option, given the filtration F0 , the high-contact condition at each
time ti =

iT
,
n

1 =e

i = 0, 1, 2, , n 1, is
(ni)T
n


N d1, (ni)T ,a
n

iT
b
i+1 e i+1 n

1e

(ni)T
n

ni
X

I2 (tj1 , tj , aj , bj )

j=1

(2.10)
bi+1 iT
n

+ ai+1 e

ni
X

I20

(tj1 , tj , aj , bj ) K

j=1

ni
X
j=1

12

I10 (tj1 , tj , aj , bj ) .